Discretionary monetary and fiscal policy with endogenous sovereign risk

How does the presence of sovereign risk affect the conduct of public policy? To answer this question, this paper studies optimal monetary and fiscal policy without commitment for a model economy with nominal public debt and strategic sovereign default. Compared to an economy without the possibility of default, economies with sovereign risk experience more volatile interest rates, which impedes the government’s ability to smooth tax rates across states. Risk of default also limits public debt accumulation, reducing the government’s incentive to use surprise inflation on average. When calibrated to the United States, the model predicts that a counterfactual increase in the average annual default probability from 0 to 1% lowers average inflation by 33%, raises the standard deviation of inflation by 18% and increases the standard deviation of the labor income tax by 73%. The transmission of exogenous shocks to real aggregate quantities is however almost unaffected by the possibility of default. For example, the presence of sovereign risk would increase the standard deviation of log real GDP by less than 1% in the experiment above. Similarly, the welfare consequences of sovereign risk are found to be of negligible size as well.